Paying for Fannie and Freddie's Mistakes

The US government's bailout of Fannie Mae and Freddie Mac should be conditional on salary caps for their top executives.

The collapsing housing bubble put two more financial institutions on their death bed last week. The government-created mortgage giants, Fannie Mae and Freddie Mac, were forced to run to the government looking for handouts as their stock price was sent plummeting.

It's not exactly shocking that two institutions who hold almost nothing but mortgages and mortgage-backed securities face a crisis when a housing bubble collapses. Nonetheless, the folks at the Federal Reserve Board, Treasury and other top policymakers were once again caught by surprise.

The basic story is very simple. In ordinary times, the prime mortgages that are the backbone of Fannie and Freddie's portfolios go bad at very low rates. And when they do default, most of the debt is covered, since the value of the house is typically close to the value of the mortgage.

The collapse of the housing bubble, however, has created extraordinary circumstances where even prime mortgages are going bad at very high rates. As many mortgages in former bubble markets sink further underwater, Fannie and Freddie now own or guarantee mortgages on homes that will lose in the neighbourhood of 50% of their value.

Furthermore, this unprecedented collapse of house prices is also sinking the mortgage insurers who would ordinarily share the losses with Fannie and Freddie. By the end of the year, it is likely that Fannie and Freddie will be bearing the full losses from foreclosures in many markets, since the mortgage insurers will have gone bankrupt.

Federal Reserve Board chairman Ben Bernanke and Treasury Secretary Henry Paulson both issued statements assuring the public that Fannie and Freddie were fundamentally sound. At the same time, Bernanke and Paulson starting filling the buckets with cash to keep them afloat. The bailout began with unlimited access to the Fed's discount window, where Fannie and Freddie can borrow at below-market rates. The next step is to have Congress approve a $300bn line of credit.

There can be no question of bailing out the mortgages giants. It would be disastrous for the housing market even in the best of times to lose the capital provided by Fannie and Freddie. They are more important than ever in the current crisis, buying up 70% of newly issued mortgages in the most recent quarter.

But there is no reason that Congress cannot put serious conditions on the bailout. These two firms are facing bankruptcy because of the incompetence of their management, which in turn helped fuel the housing bubble.

If the top management at Fannie and Freddie had recognised the bubble (yes, this is their job) and stopped purchasing loans that were used to buy houses at bubble-inflated prices, it would have likely prevented the housing bubble from growing to such dangerous proportions. It also would have prevented Fannie and Freddie from holding or guaranteeing hundreds of billions of dollars of bad mortgage debt.

In a free-market economy, people who mess up on their job are supposed to be fired. While that may be the case for custodians and dishwashers, there are different rules for managers at banks who earn six-figure, seven-figure and even eight-figure salaries. These folks just run to the Fed and Treasury and get taxpayer dollars to keep their companies in business and their salaries in tack.

It doesn't have to be this way. As one of the terms of the bailout, Congress could put a strict cap on management compensation of $2m a year (that includes salary, bonuses, stock options, personal use of company jets and anything else that has value). This can be a good first step toward reining in the outrageous salaries at financial institutions that have come at the expense of ordinary workers. We can apply the same salary caps for managers at other financial institutions that feed at the government trough.

Economists have long debated the cause of growing wage inequality in the United States. While some have argued that inequality has been driven by institutions and policy, others have maintained that it was driven by the natural development of the market.

If the bailout proceeds as planned, the answer to this question will be as clear as day. The government is explicitly subsidising the pay of incompetent bank managers. It is the effective use of lobbyists that ensures the pay of the executives of Fannie and Freddie, not their skill and hard work. Of course, if anyone in Washington cared about inequality and fairness, or even believed in the market, the executives at Fannie and Freddie would not get away with it.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.